When Buyers and Sellers Come Together – Demand and supply determine
equilibrium price and quantity exchanged
Supply is a relationship between prices and quantities supplied while demand is a
relationship between prices and quantities demanded. Given the supply and
demand schedules above, what will the price be and what quantity will be
exchanged? If we combine the two tables above, we can see how supply and
demand interact. In addition, we can identify the market price and the quantity
exchanged.
Price
$10
$9
$8
$7
$6
$5
$4
$3
$2
$1
Quantity
Supplied
5
4
3
2
1
0
0
0
0
0
Quantity
Demanded
0
0
1
2
3
4
5
6
7
8
At a price of $7, the quantity supplied and the quantity demanded are the same. At
any other price, sellers want to sell a different amount than buyers want to buy. At
$7, sellers are willing and able to supply 2 of the product and buyers are willing
and able to buy 2 of the product. In this market, the equilibrium price is $7 and
the quantity exchanged is 2.
[Caution: Students will often employ this logic. As buyers buy the
products, the amount available falls so supply falls. That raises the price,
causing buyers to buy less, etc. The quantity determined here is not the
total quantity available, nor the total quantity that buyers would like to
have. It is the quantity exchanged and it is a result of the market forces
of supply and demand. Once the price is determined, the quantity
exchanged is also determined. It is as if we are taking a snapshot of a
market; under certain market situations, demand and supply interact to
determine a price and a quantity exchanged. As Karl Seyer-Ochi, a
talented San Francisco teacher explains, “Demand is the father, supply is
the mother, and price and quantity are the children.”
Reservation prices
Sellers want to get the highest possible price for their products but they will settle
for less than infinity. They can’t, however, accept a price that is less than their
“reservation price.” Buyers want to pay the lowest price possible for products, but
they will be willing to pay more than zero. They can’t, however, pay a price that
is greater than their “reservation price.” A reservation price is a price that is so
low for sellers, or so high for buyers, that it drives them out of the market.
The seller’s reservation price is called the supply price and is determined by
production costs. The buyer’s reservation price is called the demand price and is
determined by many things including the pleasure or “utility” that a buyer expects
to get from the product and the buyer’s income. If the price is greater than the
expected utility from the product, the buyer will not buy the product at that price.
The principle of exchange states that people will only exchange if they expect to
gain more than they give. In a market a seller must cover the opportunity cost of
all resources involved in the production of the good or service. If the price is not
high enough, supplying the product is simply not worth it. Offering a car
salesperson $2,000 for a new car is not likely to encourage him to supply a new
car. There is some price, below which he will not sell the car. A buyer’s goal is to
discover that price. Similarly, asking $500 at a garage sale for a used, battered and
bruised garden hoe is not likely to encourage buyers. There is some price above
which a prospective customer will not make a purchase. A seller’s goal is to
discover that price. A buyer expects to gain a certain amount of pleasure from a
product. If the price is higher than the utility expected, the buyer won’t buy the
product.
The equilibrium price
As mentioned, buyers want low prices and sellers want high prices, but both
groups want to make an exchange. So they negotiate, and some buyers and sellers
achieve a compromise and agree upon a price at which they can indeed exchange.
This price is called the “equilibrium price.” At this price, not all buyers and not all
sellers will participate. For some buyers, the equilibrium price will be above their
demand price, and for some sellers it will be below their supply price.
At the equilibrium price, the number of items sellers are willing and able to offer
for sale equals the number of items buyers are willing and able to purchase. At
this equilibrium price, the “market clears” --- no buyers who accept the price are
turned away because the sellers have run out; no sellers end up with unwanted
inventories. There are no surprises at the equilibrium price.
This does not mean that all would be market participants are satisfied. Remember,
no economic system eliminates scarcity. For some who would like to supply the
product, the equilibrium price is below their supply price so they are unable or
unwilling to supply the product. For some who would like to buy the product, the
price is above their demand price so they are unable or unwilling to buy the
product
Unit 9: Buyers and Sellers Determine Prices
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